This morning, the House Committee on Oversight and Government Reform held a hearing entitled “Credit Rating Agencies and the Next Financial Crisis.” The purpose of the hearing was to explore the role played by credit rating agencies in the current financial crisis and to determine what regulatory reforms are needed to ensure another crisis of this nature does not occur in the future. Testifying before the Committee were the following witnesses:
- Ilya Eric Kolchinsky, Former Managing Director, Moody’s Investors Service
- Scott McClesky, Former Senior Vice President for Compliance, Moody’s Corporation
- Richard Cantor, Chief Risk Officer, Moody’s Corporation, and Chief Credit Officer, Moody’s Investors Service
- Senator Alfonse M. D’Amato, Former Chairman, Senate Committee on Banking, Housing and Urban Affairs
- Floyd Abrams, Partner, Cahill, Gordon & Reindel, LLP
- Eric Baggesen, Senior Investment Officer, California Public Employees Retirements System (CalPERS)
- Lawrence J. White, Professor, Leonard N. Stern School of Business, New York University
Chairman Edolphus Towns (D-NY) opened the hearing by noting massive failures in the credit rating system that were made apparent last fall. Since then, in his view, not much has changed. Chairman Towns warned that we “ignore this situation at our peril,” admonishing that that “credit rating agencies can be part of the problem or part of the solution in the next credit crisis.”
The first panel included testimony from two former employees of Moody’s Corporation, whose employment was allegedly terminated after they raised concerns over the quality of the company’s rating procedures. Mr. Kolchinsky described what he regarded as the main problems in credit rating agencies in general, and in Moody’s in particular, including (1) conflicts of interest stemming from the fact that the agencies performing ratings functions are compensated by those companies who issue the securities being rated, (2) the lack of independence of credit policy and compliance groups, and (3) inadequate rating methodologies. Mr. McClesky agreed with Mr. Kolchinsky’s assessment that the compliance function, at least at Moody’s, lacked independence and authority, suggesting that regulations be amended to require that compliance officers report directly to the chief executive officer or board of directors of the company. Both witnesses, in response to questions by Committee members, agreed that the Securities and Exchange Commission (SEC) was the proper agency to oversee credit rating agencies, provided it is given the time it needs to “learn the industry.” Both also agreed that the SEC should be granted the power to specify minimum requirements for the type of information that must be given to credit rating agencies by issuers of securities.
Members of the second panel testified as to how efforts to reform the credit rating industry should be focused. Senator D’Amato condemned the “inherent conflict of interests” in the issuer-pay ratings system and strongly supported the passage of a prohibition on allowing credit rating agencies to act both as a rater of, and a paid adviser to, issuers. Mr. Baggesen also took issue with the current model of compensation among credit rating agencies, noting that ratings of creditworthiness were no longer “in the same category of integrity” as were other industry measures, due in part to the conflicts of interest existing in the current system.
Mr. Abrams, meanwhile, blamed the current industry problems on an overreliance by the market on credit ratings agencies, remarking that credit ratings are an assessment of future creditworthiness of an issuer, not of the market value, liquidity, volatility, or other characteristics of a security, and, therefore, cannot be a complete measure of the soundness of an investment in a security. Mr. White agreed with Mr. Abrams regarding the overreliance of the market on credit rating agencies, recommending that steps be taken to “eliminate the force of law that ratings have” and increase reliance on market forces instead.
The hearing concluded with Chairman Towns again expressing his concern over the conflicts of interest that exist in the credit rating industry. Representative Darrell Issa (R-CA) concurred, noting again that it is not possible to “mend system without significant change.”